On December 16th 2008, in what Ben Bernanke averred took a tremendous amount
of "moral courage", the Federal Reserve officially arrived at its Zero Interest
Rate Policy. ZIRP was a huge win for borrowers because it drove down the carrying
cost of debt to historic lows. Unfortunately, savers didn't fare as well.
Those frantic savers were forced to reach for yield far out along the risk
curve. And an obliging Wall Street issued over $1 trillion in new junk bonds
at the lowest spreads to Treasuries in the 35 year history of the junk debt
market. To put this in perspective, the entire high yield market had previously
hit its frothy peak of $1.2 trillion in the bubbly days of 2007, in October
of last year junk bond debt alone hit $1.7 trillion, adding to the total $2.6
trillion high yield debt market.
Through these newly issued Junk-bonds investors generously financed America's
shale boom that is now going bust. Junk debt also provided the lowest-grade
borrowers cushy terms such as covenant-lite offerings and PIK (Payment-in-Kind
toggle), which allows issuers to pay some of the interest due by borrowing
new debt. And also financed lavish dividend payments for those debt holders.
But now the Fed's mission is to prove to Wall St. and Main St. that nearly
eight years' worth of ZIRP has succeeded in saving the economy. Therefore,
it has finally embarked on its path to interest rate normalization. However,
on the way down this road to normalization the junk debt market has started
to discount increased borrowing costs and a U.S. recession, which is the bane
for high-yield debt.
The carnage has just begun. Lucidus Capital Partners-an investment manager
specializing in corporate credit--recently announced it was liquidating its
entire portfolio and returning $900 million to clients next month. Third Avenue
rattled markets when it announced December 9th that it's liquidating a $788.5
million corporate debt mutual fund and delaying distribution of investor cash
to avoid even bigger losses. And Stone Lion Capital Partners has also halted
cash redemptions for its investors.
But as usual the Wall Street cheerleaders quickly provided a myriad of excuses
for these individual failures and eagerly offered reasons why this isn't systemic.
They claim Third Avenue focused on ultra-high risk illiquid assets that didn't
belong on a mutual fund platform. And that Lucidus had one large investor who
wanted his money back. Or, that outside of energy these junk bond funds are
rock solid. However, within the Third Avenue Focused Credit Fund 78% of the
top ten holdings were not energy related at all.
This is eerily reminiscent of similar assurances given at the onset of the
sub-prime fund failures back in 2008. As the Bear Stearns High-Grade Structured
Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged
Fund brought down the legendary investment bank that bears its name, most pundits
were confident that these particular funds represented isolated cases. Those
same Wall Street apologist were busy pontificating that the failure of Bear
Stearns was due to a mismanagement issue and not part of a larger problem in
the mortgage market; and certainly had nothing to do with a systemic problem
in financial institutions or the global economy.
Likewise, this time around the issue is not limited to just a small subsection
of high-yield junk. Remember those CLO's (collateralized loan obligations)
that almost brought down the entire economy in 2008? They are back and are
now being issued at a record pace. Yield hungry institutional mangers and retail
investors have been lured into these debt securities that are collateralized
by loan pools consisting of highly illiquid bank loans.
To make matters worse, leveraged bank loans outstanding, which have been the
engine of the recent financial engineering of M&A and stock buybacks, amounts
to nearly $900 billion, up 80% from the post crisis bottom.
Investors in search of a higher yield coveted the mortgages of unqualified
homeowners leading up to the Great Recession. Today, they have turned their
pursuits to low-credit corporate debt and the leveraged loans of distressed
borrowers.
In 2007 the entire mortgage market was worth $10.7 trillion dollars; $4.6
trillion of which was composed of sub-prime and Alt-A loans. Currently, the
high-yield debt market is more than 55% of that amount today. However, just
like the carnage in the Sub-prime mortgage market was not at all contained,
the entire credit market spectrum from Junk to Sovereign debt is now in a bubble.
And because prices have been artificially manipulated by the Fed for so long,
all bond yields will eventually spike either due to inflation and/or insolvency.
For seven years our economy, and especially our stock market, have grown off
the back of asset bubbles and artificially suppressed interest rates. As these
misallocations of capital are revealed Janet Yellen and company will realize
our fragile economy cannot withstand the pressures of interest rate normalization.
Therefore, she will be compelled to take back her quarter point rate hike in
an act that I'm sure Wall Street will categorize as "mortified courage."
Perhaps the most important take away from the Great Recession was that the
blowup in sub-prime eventually exposed the bubble in real estate and the banking
system as a whole. And as the market begins to see the forest behind the high-yield
trees, it will realize that after seven years of ZIRP and QE the true bubble
exists in the entire universe of fixed income.
